Following a disappointing employment report and a pullback in
the stock market, by the middle of April some investors and
commentators were clamoring for the Federal Reserve to launch into
a third round of
quantitative easing
, or "QE3" as it is popularly known.
The expectation seems to be that any economic or market
disappointment should prompt an immediate and automatic response by
the Fed -- like yanking on a dog's chain and having it come to
heel. However, after two previous rounds of quantitative easing,
it's worth asking who is yanking the chain, and whether Ben
Bernanke should be held on such a short leash.
Through-the-looking-glass investors
To understand why there is such vocal support for QE3, it helps
to start with a class of people who could be called
through-the-looking-glass investors. They seem to exist in a world
where up is down and down is up, but there is a reason for
that.
Through-the-looking-glass investors are the ones who seem to
welcome bad news, in the hope that it will prompt another round of
quantitative easing. They are the reason why a negative economic
announcement will sometimes be followed by a stock market rally,
and by breathless commentators on television waving their arms and
exclaiming that QE3 is as good as here.
These people are not -- appearances sometimes to the contrary --
nuts. They just live in the narrow world of stock and bond
valuation. Stocks are generally valued on a model in which earnings
are the numerator and interest rates are the denominator. In such a
model, value can rise either because the numerator (earnings) rises
or because the denominator (interest rates) falls. Since it is
often easier for the Fed to lower interest rates than for companies
to produce earnings gains, these through-the-looking-glass
investors are very enthusiastic about the Fed taking action, even
if it means a short-term earnings disappointment.
Bond investors live in an even more limited world. Since their
numerator is the coupon on the bonds they own, it is essentially
fixed in place, and all they can root for is for the denominator
(again, interest rates) to fall. So they too are rooting for
QE3.
Diminishing returns
The catch is that there are diminishing returns to all of this,
and not just for the
long-suffering depositors
stuck with low interest rates on CDs, savings accounts and money
market accounts. As interest rates approach zero, the ability of
the Federal Reserve to lower them further naturally diminishes.
Plus, history suggests that there will come a time when the Fed may
have to raise interest rates to battle inflation.
In short, whether it's QE3, QE4 or QE5, eventually these actions
will become like Rocky movies -- the sequels just won't be any
good. At that point, even the through-the-looking-glass investors
will have to root for actual earnings growth -- something that
would benefit stocks, job-seekers and
savings accounts
all at once.